Monday, September 22, 2008

Economist Nouriel Roubini, who has been pretty much dead-on about all things economic over the past few years, held forth in yesterday's Financial Times:

The shadow banking system is unravelling

By Nouriel Roubini

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.

The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.

The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.

The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.

The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.

Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.

We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.

The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.

European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.

Thus the financial crisis of the century will also envelop European financial institutions.

The writer, chairman of Roubini Global Economics (www.rgemonitor.com), is professor of economics at the Stern School of Business, New York University .

Roubini predicts that the hedge funds -- all of them leveraged to the gills -- will be taken down next, and we'll be slogging through a dandy recession (We're traipsing through the shallow end already.)

29
comments:

Anonymous
said...

>>Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

I love these circular chicken-and-egg philosophical paradoxes economists and politicians wrap their 'scientific' theories in. Basically, what he's saying is "We don't know what we don't know." That's why Paulson and Bernanke have panicked. They just don't know what they don't know.

After the election, expect inflation, rising energy, and a heavy tax burden to walk through your front door, thanks to the small government GOP. What a legacy!

Its also worth noting that you can see a surprising correlation between the banks collapsing and the percentage of "CRA" loans that they had. providing CRA loans was a policy that was supposed to level the playing field and provide loans for all families regardless of the money they make. Its interesting that a quasi socialist policy like that, which was anchored in charity and not greed, had a major part in banks going belly up. Too many of the low income families didn't pay back the banks

Here is the wikipedia entry:http://en.wikipedia.org/wiki/Community_Reinvestment_Act

"Its interesting that a quasi socialist policy like that, which was anchored in charity and not greed, had a major part in banks going belly up. Too many of the low income families didn't pay back the banks"

Well, you've managed to contradict yourself withing one paragraph. If it was based in "charity and not greed", why would low income families have to pay the loans back? Charity is not a loan; it's a gift.

But of course, the banks and lending institutions made these loans out of the goodness of their hearts, and not to earn a return on their investments, right? Sheesh.

You sound like my uncle, who rants constantly about the evils of "Democratic social programs", and then goes to the bank once a month to cash his Social Security check.

Leave it to small gov. idealogues to exploit a 1977 Carter admin. loophole.

Bankers despise gov. for devaluing the dollar. Government despises bankers for betting against US interests. Between this massive gulf, scumbags like Mozilo and Arnall step in to offer their predatory lending services under the auspices of small government. Look at Blackwater and Iraq, Enron and energy markets. These scumbags are have collectively drowned us all because our government is paralyzed with its own massive debt. They all say the same thing - we were just kicking the can further down the road. These people should be in jail serving life. Meanwhile, we continue to implode. If anything good can come out of this for the American people, I hope it's the realization that there ARE NO MORE SUPER POWERS in this world.

"Because they should have never been obligated to grant the loans in the first place."

Couldn't agree more - even though you conveniently cut off the sentence that finished my point. Where we differ is that I'm not trying to put a partisan slant on what's going on. You're conveniently hopscotching every GOP administration and attempting to assign blame to Democratic administrations. There's plenty of blame to go around on both sides of the aisle.

There's nothing at all "nefarious" about loans, but there was nothing charitable about them either.

This bailout is the largest government-sponsored transfer of wealth ever in the history of civilization. I thought you Repubs were against that kind of thing. Or maybe it's only when it's going the other way...

It's a fact that the Democrats forced loan companies to give loans to families that fundamentally had little chance of paying them back. In order to be "fair". Yeah, and look at those families now. I have a friend in that predicament.

And it's a fact that President Bush tried 13 TIMES to do something about Freddie Mac and Sallie Mae. And in 2005, John McCain introduced a bill in Congress to try to look into the looming mess. He warned that if something weren't done, bad things would happen. The Dems shot it all down. And why? Because Freddie and Fannie give huge contributions to the Dem party, that's why. Obama especially got huge wads of cash. McCain, by contrast, got very little...maybe because of the aforementioned bill, hmmm?

So when Nancy Pelosi says the Dems have nothing to do with this mess, that it's all the Repub's fault, you can toss that into her other collection of lies, along with "I bring a message of peace from Israel..."

I have no idea what bill John McCain introduced in 2005, but if the year is accurate, the Republicans controlled both houses of Congress. If the bill failed, it could not have been due to the Democrats. Some Republicans had to disagree with it.

That's funny. I recall President Bush trying two-thousand times to steer this country into spending a fortune on a useless war - and succeeding quite famously. I kind of missed those 13 times he mentioned housing. I do remember him telling us the economy was fundamentally strong. The fact is, fiscal responsibility of any kind was this administrations last priority. They delegated that job to the free market and 'small' government. It's not a Democrat or Republican thing. It's the whole idiot idealogues and their cronies thing, capitalist, socialist, and otherwise.

And here we are at the end game, and guess which group they are choosing to save? Not you, but the banks - corporate welfare first, people later. So much for small government. And now your dollar is worth half as much as it was yesterday next time you go to the store and buy milk - after the election, course.

George Bush is telling you this - I don't want the people so fucking mad at the state of their country that they do things that are out of our control, like hitting the streets and breaking windows. The markets are already doing things out of our control, and my buddies Bernanke and Paulson are spooked. So, they are choosing a 'soft' crash, so none of what is really happening on Main Street hits the news all at once. They don't want us to know how mortally wounded we are. And it is looking mortal.

In the (Republican majority) 109th Congress, 2005-2006, bills were introduced in the House and Senate to revamp the oversight of Fannie and Freddie.

The House version of the bill was the Federal Housing Finance Reform Act of 2005, HR1461 and the Senate version was Federal Housing Enterprise Regulatory Reform Act of 2005, S190.

HR1461 was introduced in April 5, 2005, subsequently amended, and passed the House on October 26, 2005 by a 331-90 vote. S190 was introduced in the Senate on Jan 26, 2005, sponsored by Hagel and co-sponsored by Dole and Sununu. McCain was not a co-sponsor.

S190 was discussed in the Senate Banking Committee on July 28, 2005 with the result, "Ordered to be reported with an amendment in the nature of a substitute favorably" ...

The bill died in a Republican-controlled committee and never came to the floor of the Senate or back to the Senate Banking Committee for reconsideration. S190 died in committee.

On May 23, 2006, Fannie and Freddie's regulator, the Office of Federal Housing Enterprise Oversight, issued the results of their 27-month long investigation of Fannie Mae's shenanigans. The report was widely reported and was scathing in its criticism of Fannie Mae. "Regulators Denounce Fannie Mae."

Two days later, in an amazing act of prescience, McCain gets up in the Senate and reveals to the unknowing masses that Fannie Mae has problems by regurgitating some findings of the report and signs on as a co-sponsor of S190.

And for the icing on the cake, HR1461 and S190 would actually weaken the regulation of Fannie and Freddie. Even the conservative think tank American Enterprise Institute thought these were bad bills: Reform That is Worse Than Current Law. Even Bush thought the bills were too weak: Bush says HR1461 too weak.

So let's review: McCain isn't a co-sponsor until he sees which way the wind's blowing, then makes one speech, and jumps on the band-wagon.

But the band-wagon never goes anywhere, because the bill dies in a Republican run committee.

And of course, today conservative blogs tout this as a prescient, Mavericky McCain getting out in front of a Very Important Issue and being thwarted by nasty Dems in the pocket of Fannie and Freddie.

John McCain has a habit of tilting at windmills after he sees which way the air currents are drifting. Just like most politicians.

And yeah. Obama took a lot of political contributions from Fannie and Freddie employees, most of whom were staffers.

Its also worth noting that you can see a surprising correlation between the banks collapsing and the percentage of "CRA" loans that they had. providing CRA loans was a policy that was supposed to level the playing field and provide loans for all families regardless of the money they make. Its interesting that a quasi socialist policy like that, which was anchored in charity and not greed, had a major part in banks going belly up.

* CRA loans constituted only 23% of all loans and 9.2% of high-cost loans.* CRA loans were twice as likely to be retained in the originating bank’s portfolio than loans made by other institutions.* CRA loans were less likely to be foreclosed upon than other loans.

The deregulation craze began and ended in the 90s. That was when the media was deregulated, that was when the banking laws were deregulated and the buck stopped at the executive branch with William Jefferson Clinton signing the legislation.

In the case of media, the gaffe was recognized immediately as rates rose and choices shrank. In tyhe case of banking deregulation it took a while for greed to push the situation to collapse. In both cases the genie was let out of the bottle long ago.

But it CERTAINLY wasn't deregulated under the current administration. You can huff and puff and hold your breath and cry about the war or any number of grievances, but the facts will not change. the last administration deregulated waaaaaay too much.http://tinyurl.com/3puj2q

And deregulation CERTAINLY wasn't fought against under the current one.

And Paulson just stated today "I have never been a proponent of intervention." as he pushes through the largest government intervention of 'independent' banking in history.

To pay off the largest 'small' government 'privately' contracted mercenary war in history.

The only thing worse than Mozilo's little Wall Street accounting time bombs were Roves red state crusading evangelist small government 'conservatives' that were sent to DC to save us all from the Evil abroad. And now it is making the whole of Europe and Asia vomit.

I'm curious to know what opinion Robiscus has toward the Bush/Paulson/Bernanke request for imperial power over what's left of the American free market. Thumbs up or thumbs down? Print more money or let the people have a taste of what's really been going on - give 'em the free market medicine. Not a great choice ol' George has left us with, is it?

Then again, he's all about simple thinking, isn't he - for us or against us? Only these conservatives could turn conservatism completely upside down.

Mr. Robiscus is pulling a little logic trick that I am seeing from some very embarrassed Republicans looking to deflect blame for the consequences of irresponsible rampant deregulation. The legislation was authored and passed by a Republican congress. Is Clinton's decision not to veto the legislation really make him equally culpable for the results? That's quite a reach.

By all accounts, both sides bear the blame. I'm simply citing that economic booms and busts are sewn years before they are reaped. Yes, it was a republican congress. It also was a democratic president.

AND the Senate approved the final bill by 90 to 8. The House did the same by a vote of 362 to 57.

Deregulations didn't work out they way BOTH PARTIES had hoped it would.

The disitinction I think is noteworthy is that McCain's camp isn't trying to spin this as a partisan issue. They aren't reinventing the facts to blame the democrats when they definitely could. He's saying what he has always said that the country comes beofre party.

Whereas Obama is pulling the same parlour tricks and revising the history of the policies that created this mess. The problem is Washington acting at the behest of big money. A problem in which both parties are equally and indisputably entrenched.

Greenspan played his part, but it's too convenient to place blame at the foot of a single person. Praising him for his 'success' was just as ill conceived.

This is institutional and systemic corruption, a government/financial revolving door. Accounting, energy, defense contracts, etc, etc. The money always leads back to DC. Corruption. Obama won't call it like it is because his pals are knee deep, too. McCain is just confused at this point.

Wall Street packaged "toxic waste" into CDOs. Ratings agencies blessed the financial poison with AAA-ratings, declaring them as safe as U.S. Government Treasuries. That's how this crap got into pension funds, municipal funds and central bank portfolios.

This would be OK if the problem was just mortgages going into default. However, Wall Street sold unregulated Credit Default Swaps on these mortgages to as many buyers as they could. A CDS is an "insurance policy." Wall Street thought that housing prices would always rise, so they did not fear that they would ever have to fulfill these CDS obligations. So they sold as many of these "insurance policies" as they could and made tons of $$$ selling CDS, but they didn't set enough cash aside to meet these insurance obligations.

In 2003, Warren Buffett warned investors years ago that derivatives like Credit Default Swaps were "weapons of mass financial destruction." No one listened to him, and here we are now.

If you read between the lines of Bush's speech, it just kicked the can yet again and gave both regulatory and deregulatory proponents ammunition to continue the private vs. public war for the next 50 years. He blamed the semi-privatized stature of Freddie and Fannie and the overly independent Lehman. Here comes inflation. I could hear Paulson's treasury printing money all night long. This is no re-set. It is the exact opposite. Amazing.